Should I Use a 15-Year or 30-Year Mortgage?

Summary: In this article, we will compare the pros and cons of the 15-year mortgage and its longer 30-year counterpart. The shorter-term loan may be a good option for borrowers who are most concerned with long-term wealth and the total amount of interest paid over the life of the loan. The longer term might be a better option for borrowers who are most concerned with the affordability of their monthly payments in the short term.

On the surface, the differences between a 15-year and 30-year mortgage may seem elementary. One has a payback term that is twice is long as the other. So the monthly payments will be smaller when spread over a longer period of time. This much is true, and somewhat obvious. But there are more factors a borrower must consider when deciding between the 15-year vs the 30-year home loan, whether it’s for purchasing or refinancing. Here are some of the pros and cons you need to consider.

15-Year = Shorter Path to Home Equity

The 15-year mortgage loan helps you build equity in your home at a much faster rate than its 30-year counterpart. I’ll explain why in a moment. But first, a quick definition:

In real estate terms, equity is the amount of ownership you have in your home. If your outstanding mortgage debt equals half the market value of your home, you have 50% equity. So you own half of your house, financially speaking. Mathematically stated: (appraised market value) – (amount owed on mortgage) = (home equity).

So how does the 15-year mortgage help you build equity faster? There are two reasons:

First of all, there is the shorter term to consider. By cutting the term of the loan in half (30 vs 15), you’ll be increasing the size of your monthly payments. This will lead to a faster accumulation of equity, especially when you factor in reason #2:

There’s also about a 99% chance you will secure a lower interest on the 15-year mortgage, vs the 30-year loan. Traditionally, the rates are lower for the shorter-term loan.

This table illustrates the point made above, regarding the lower rates associated with 15-year loans:

Snapshot of average mortgage rates on March 1, 2012

The table above is a snapshot of the average mortgage rates available on March 1, 2012, according to Freddie Mac. These rates may not be accurate by the time you read this article. But that’s not the point. I want you to focus on the difference between the 30-year fixed-rate mortgage (FRM) and the 15-year FRM. Of the two, you can see that the shorter-term loan has a lower interest rate. This is normally the case. So you can build equity faster by paying less interest over a shorter period of time.

Affordability in the Short Term vs. Savings in the Long Term

Due to the shorter term, the monthly payments on a 15-year mortgage may be unaffordable for many home buyers. At least within the price range they desire. This is why so many people opt for the 30-year loan, especially when buying a first home. Amortizing the loan over a longer period of time will reduce the size of the payments. So with the longer payback option, the buyer can afford a larger mortgage and a nicer home.

On the other hand, there are those buyers who have the luxury of choosing between the 15 and 30-year mortgage. They can afford the monthly payments either way, regardless of how long the term might be. Now it comes down to a question of minimizing the payments versus maximizing wealth. Here’s how to weigh the pros and cons:

Are you more concerned with your disposable income in the present, and in the near future? If so, you are probably better off choosing the longer term to reduce the size of your monthly payments.

Or, are you more concerned with your long-term wealth and the amount of money that goes toward interest? If you fall into this boat, you might want to choose the shorter term to reduce the amount of money you pay in mortgage interest.

Let’s look at the difference between a 15-year and 30-year mortgage loan, in terms of the total amount of interest paid over the life of the loan.

Due to the longer term, the 30-year mortgage has a smaller monthly payment of $1,423. The 15-year loan, on the other hand, has a lower interest rate but a larger monthly payment of $2,099. This is due to the fact that the loan is repaid in half the time, when compared to the first scenario.

So even with the higher interest rate assigned to the 30-year loan, the payments are smaller because they are spread out over a longer period of time. This is certainly attractive in the short term. But what about the long view? Look at the total amount of interest paid over the life of these two loans. It adds up to $212,500 for the 30-year mortgage and $77,868 for the 15-year. That’s a difference of $134,632. This is just interest — not the principal. That’s how much more you would pay in interest over the life of the longer loan. Why? Because you are paying a higher interest rate for twice the number of years.

The Payments Won’t Necessarily Double With a 30-Year Mortgage

There’s something else I want you to notice about this graphic. It relates to a common misconception people have about the differences between 15-year and 30-year mortgages. Notice that the payment is not doubled for the shorter loan. Not even close. How can this be so? Many borrowers assume that the monthly payments would be doubled, since the payment period is only half that of the 30-year loan. But it typically doesn’t work out that way. Amortization is the reason for this.

Remember, the borrower with the 15-year mortgage is paying a lower interest rate over a shorter period of time. As a result, there is less interest spread over the term of the shorter loan — and less interest added on to the monthly payments. So, even though the repayment period is shorter, the monthly payments are not necessarily doubled.

This is an important factor to consider as you weigh the pros and cons of these financing options. If you use a mortgage calculator to determine your monthly payments for a 30-year loan at a certain price point, you shouldn’t assume the payments would be double for a 15-year term. Do the math, and you might find that the payments are still affordable at the shorter length. They may only be about 50% higher, as in the illustration above.

When you add the fact that a 15-year mortgage builds equity much faster, you can see why some borrowers opt for the shorter term — despite the larger payment that results from that choice.

As You Compare Your Mortgage Options, Consider…

Let’s recap. Here are the key questions you need to ask as you compare the 15-year and 30-year mortgages:

Are you more concerned with your long-term wealth picture, or short-term affordability?

Do you want to build equity as quickly as possible? If so, the shorter term might be best for you.

If you are a buying a home, can you afford the larger payments of a 15-year mortgage? Or do you need to spread the payments out to buy the kind of house you want?

How will the larger payments associated with the shorter loan affect your quality of life? Don’t guess. Do the math. Take a good, hard look at the amount of money you spend each month, including savings and entertainment expenses. Can you comfortably afford the higher monthly payments without being “house poor”?

How long do you plan to stay in the home? (Hint: If this is a starter home, you’re probably better off using a 30-year loan to reduce the size of your payments.)

Are you an active investor? Is it important for you to have extra money to invest right now, and in the near future? If so, you might want to choose the option that yields the smaller payment, which is typically the 30-year mortgage.

In closing, I want to remind you to do the math and avoid making assumptions. Consider the pros and cons outlined in this article, and weigh them against (A) your financial priorities and (B) your long-term plans for the home. The 15-year mortgage has a repayment period that is half the length of its 30-year counterpart. But that doesn’t mean the payments will double for the shorter term.

If you go with the shorter loan, you will likely secure a lower interest rate than a 30-year fixed mortgage — possibly more than half a percent lower. And you’ll carry that interest rate for a much shorter period of time. So the difference in the total amount of interest paid over the life of the loan could be significant.